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Application of Entity Classification Elections to Shelf Company Acquisitions

By Jennifer E. Breen, J.D., and Daniel J. Wiles, J.D., Washington, DC

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Tax Section

Foreign Income &
Taxpayers

When electing the entity
classification of a newly acquired eligible entity, the
taxpayer must consider several procedural issues,
including:

The desired effective date of the
election;

How many members the entity has,
which in turn affects the types of classification
available to elect; and

The identification
of the individual or individuals who will sign Form 8832,
Entity Classification Election.

Shelf Companies

These issues may be
more complicated when a U.S. person acquires a foreign shelf
company. A shelf company generally is defined as a
ready-made company that has fulfilled all requirements for
legal registration under the local laws in the jurisdiction
in which it was formed. Shelf companies, which commonly are
formed by law firms, may be acquired to bypass lengthy local
registration and incorporation processes.

When filing
an entity classification election on acquisition of a shelf
company, the taxpayer must determine whether the entity’s
classification was relevant prior to acquisition. Under
Regs. Sec. 301.7701-3(d)(1), a foreign eligible entity’s
classification is relevant when its classification affects
the liability of any person for federal tax or information
purposes. If the shelf company has never been relevant prior
to acquisition, the company’s classification initially will
be determined upon relevance (i.e., the date of
acquisition), as on that date the classification has an
effect on the U.S. person’s tax liability or information
reporting responsibilities.

In general, shelf
companies formed by foreign law firms or organizations are
not relevant for U.S. federal income tax purposes prior to
the date of acquisition by a U.S. person. However, should
conditions exist within the foreign firm or organization
that trigger the relevance of its formed shelf companies,
this relevance may affect the selection of the election’s
effective date and the signature requirements of the
election itself.

Under Regs. Sec. 301.7701-3(d)(2),
if it is determined that an entity is not relevant for U.S.
federal income tax purposes prior to acquisition, an
election under Regs. Sec. 301.7701-3(c) is considered an
initial classification election. In this instance, an
election seeking an initial classification, effective on the
date of acquisition, requires a signature from either:

Each member of the electing entity who is an
owner at the time the election is filed; or

Any officer, manager, or member of the electing entity
who is authorized to make the election.

Because the election upon acquisition, and therefore upon
relevance, is considered an initial classification election,
the prior owner—the foreign law firm or organization—is not
required to sign the election.

If the entity is
determined to be relevant prior to acquisition, the entity
will have possessed a U.S. classification prior to that time
as well, by default if not by election. Any postacquisition
election is considered a change in classification. If the
entity wants to make this change in classification effective
on the date of acquisition, additional signature
requirements set forth in Regs. Sec. 301.7701-3(c)(2)(i)
would apply.

Specifically, Regs. Sec. 301.7701-3(g)
provides that because the entity is making an elective
change in classification, certain deemed events occurred at
11:59 pm the day before the effective date of the election,
such as a deemed liquidation when an entity changes from a
corporation to a disregarded entity. In these instances, the
owner of the shelf company on the date of the deemed
transaction (i.e., the foreign law firm or organization)
must also sign the election. If the shelf company and its
new owner wish to avoid this additional signature
requirement, they must select an effective date later than
the date of acquisition, such as the day after
acquisition.

Nominee Relationship

Law firms in some foreign jurisdictions have recently
formed shelf companies, with the law firm acting as a
nominee or as an agent of another party. The law firm holds
nominal legal ownership of the company for a short time
period as a nominee of the entity (its client). In these
instances, it must be determined whether the owner for
federal tax purposes is the foreign firm or the party for
which it is acting as an agent.

Although the
regulations do not provide guidance on this point, certain
private letter rulings and other guidance address the
nominee relationship in the entity classification context.
In this guidance, the IRS considered all facts and
circumstances of the situation in determining whether the
nominee acted as a mere agent of the principal, had a voice
or a vote, and had a right to distributions, if any, and
also whether there was a nominee agreement in place. (See
Letter Rulings 199914006 and 200201024 and Chief Counsel
Advice 200501001.) In other words, the IRS examined the
substance of the relationship to determine whether the
equity holder was the agent or the principal.

Observations

If a foreign firm has formed
an entity and has held the interest in that entity on behalf
of its client, and if it can demonstrate the characteristics
articulated in the guidance addressing this type of
relationship, the nominee firm should be considered to
“stand in the shoes” of its client. Under that view, the
nominee firm would not be considered an owner at any time,
and the signature requirements under Regs. Sec.
301.7701-3(c)(2)(i)(A), concerning the signature of existing
owners, and Regs. Secs. 301.7701-3(c)(2)(ii) and (iii),
concerning the signature requirements for prior owners,
would not apply. However, the points discussed above must be
reconsidered. If the true beneficial owner is a U.S. person,
for example, the entity would be relevant upon formation,
and any election should be made effective on that date.

The seemingly simple procedural provisions for valid
entity classification elections in fact are complex, and
selection of the appropriate effective date and satisfaction
of the signature requirements are important to valid and
beneficial elections. With the promulgation of Rev. Proc.
2009-41, expanding the availability of retroactive
corrections of elections (including changes of elections),
these rules should be reexamined and corrections made under
this simplified process if necessary.

Editor:
Annette B. Smith, CPA

EditorNotes

Annette Smith is a partner with PricewaterhouseCoopers
LLP, Washington National Tax Services, in Washington,
DC.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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